Solutions to end-of-chapter material

Questions

1. Three special items are shown on the income statement after income from continuing
operations—discontinued operations, extraordinary items, and cumulative effect of a change in
accounting principle. These are segregated from regular earnings and shown net of taxes
because these items contain special information that should not be buried in regular earnings.
This allows the use of regular earnings in assessing a firm’s future performance.

2. A firm may wish to change accounting methods to improve net income for the year. Also, many
times the accounting standards are changed, and the company is required to change
accounting principles. The accounting standards discourage voluntary changes by requiring the
company to disclose the change on the face of the income statement, after income from
operations. That is, the company is not allowed to hide the change from the users of the
financial statements.

3. An item of income or loss shown after income from continuing operations must be shown minus
the tax expense or tax savings effects, i.e., as an after-tax amount.

4. Comprehensive income includes all changes in stockholders’ equity during a period except
those resulting from contributions by stockholders and distributions to stockholders. There are
two parts of comprehensive income: net income and other comprehensive income. Rather than
including those gains and losses on the income statement, they are reported as a direct
adjustment to shareholders’ equity. Other comprehensive income is shown in the shareholders’
equity section of the balance sheet, and also on the statement of changes in shareholders’
equity.

5. Items included in other comprehensive income include gains and losses from foreign currency
translation and unrealized gains and losses on certain types of investments.

6. The three types of investments in securities are classified as follows:

• Held to Maturity—reported at amortized cost;
• Trading—reported at current market value on the date of the balance sheet and any
unrealized gain or loss is reported on the income statement;
• Available for Sale—reported at current market value on the date of the balance sheet and any
adjustment is made to shareholders’ equity and is included in other comprehensive
income.

7. The gain or loss from trading securities is included in the income statement, and the gain or
loss from available-for-sale securities is not included on the income statement but is shown in
the shareholders’ equity section of the balance sheet.

8. Horizontal analysis is a technique for evaluating a series of financial statement data over a
period of time. The purpose is to express the change in an item in percentages based on a
base-year amount.

9. Vertical analysis is an analysis technique that is similar to horizontal analysis, but the analysis
involves items on a single year’s financial statement. Each item in a financial statement is
expressed as a percentage of a base amount on the statement. For example, a common
income statement analysis uses sales as the base amount and then expresses the other income
statement items as a percentage of sales.
10. Liquidity
current assets
Current ratio:
current liabilities
Acid-test ratio (Quick ratio):
cash + short-term investments + net accounts receivable
current liabilities

201
202 Chapter 11 Financial Statement Analysis
Working capital: current assets – current liabilities

cost of goods sold

Inventory turnover ratio:
average inventory

net credit sales

Accounts receivable turnover ratio:
average net accounts receivable
11. Solvency
total liabilities
Debt to equity:
total shareholders’ equity

income + interest expense + taxes

Times interest earned:
interest expense
12. Profitability
net income + interest expense
Return on assets:
average total assets
Return on equity (sometimes called Return on investment):
net income − preferred dividends
average common shareholders’ equity

gross margin
Gross margin ratio:
sales
Earnings per share (EPS):
net income − preferred dividends
average number of common shares outstanding

SE11-14
Low Light Company: Analysis of trends in ratios

a. From the current ratio, we can see a trend of increased liquidity. The relative size of current
assets in relation to current liabilities is increasing steadily. From the acid-test ratio, we can see
that the most liquid assets are decreasing in relation to current liabilities.

b. As the most liquid assets are decreasing (cash, short-term securities, and net accounts
receivable), the increase in total current assets must be in inventories or other current assets
not included in “quick” assets.

SE11-15
Debt to equity ratio
 Financial Accounting 1/e 203
total liabilities
Debt to equity ratio =
total shareholders’ equity
The company may have increased its total debt (current liabilities plus long-term liabilities) or it may
have decreased its shareholders’ equity (contributed capital plus retained earnings).
204 Chapter 11 Financial Statement Analysis
SE11-16
Accent Company: Return on assets ratio

net income + interest expense

Return on assets =
average total assets

net income − preferred dividends

Return on equity =
average shareholders’ equity
a. Assets are increasing in relation to the related returns (net income) earned plus interest
expense. The profitability to stockholders is increasing (return on equity).

b. Net income less preferred dividends has increased in relation to equity. Given the trend in both
ratios, one possible explanation is that the company has taken on more debt to finance
additional operating assets. This is referred to as leveraging. Therefore, if profits increase, the
return on equity increases because the size of equity has remained relatively stable.

SE11-17
Archibold Company: Price-earnings ratio

market price per share

Price-earnings ratio (PE ratio) =
earnings per share
The market price is rising in relation to the earnings per share. Investors and financial analysts
believe the PE ratio gives an indication of the future earnings. A high PE ratio indicates a belief that
the company has the potential for significant growth. Therefore, investors are willing to bid up the
price per share.

Problems—Set A

P11-1A
Classifying items by financial statement and section

Two of these items are not shown on the income statement: Other comprehensive income and
Investments held to maturity. Other comprehensive income is reported as a direct adjustment to
shareholders’ equity. Investments held to maturity are reported at original cost (plus or minus any
discount or premium amortization) as assets on the balance sheet.

All other items would appear as shown below:

Investments in trading securities will be shown at market value on the balance sheet and any
unrealized gain or loss will be included in the income statement.

Net income from operations will be shown on the income statement after income tax expense and
before items from discontinued segments and cumulative effects of change in accounting principle.

Gain on sale of discontinued segment will be shown on the income statement after net income from
operations and after income or loss from discontinued segment operations. It is shown as follows:
 Financial Accounting 1/e 205

Gain on sale of discontinued segment,

net of taxes of $14,000 $126,000

Cumulative effect of change in accounting principle will be shown on the income statement after the
items from discontinued segments as follows:

Cumulative effect of change in accounting principle,

net of taxes of $10,000 $49,500

P11-3A
Sherwin Williams: Ratio analysis

1. Note that formulas shown here use the available information for Sherwin Williams.

Ratio Definition 1999 1998

Liquidity
Current ratio total current assets 1.3 1.4

total current liabilities

Acid-test ratio EMBED Equation .52 .56
(also
*short-term net current
known as cash + investments + receivables
the quick
ratio)
total current liabilities
* no short-term securities available

Working current assets – current liabilities * $407,515 $435,317

capital * figures are in thousands

Inventory cost of goods sold 2.9 3.0

turnover
ratio *average inventory
* used current year figure, and
inventory = current assets –
(cash + net current receivables)

Accounts net sales 8.3 8.2

receivable
turnover *average net accounts receivable
ratio
* used current year figure

Solvency
Debt to equity total liabilities 1.4 1.4

total equity
Times interest net interest income 9.0 7.1
earned
income + expense + taxes
interest expense
Sherwin Williams: Ratio analysis

Ratio Definition 1999 1998

Profitability
206 Chapter 11 Financial Statement Analysis
Return on net income − preferred dividends* 17.8% 16.5%
equity
** average common shareholders’ equity
* no preferred dividends
beg. SE + end. SE
**
2
Gross margin gross margin 44.9% 43.2%
percentage
sales
2. The decrease in the current ratio and acid-test ratio indicates that liquidity has decreased.
Increases in inventories are indicated by the slight decrease in the inventory turnover ratio. The
accounts receivable turnover ratio indicates that total sales may have increased in relation to
credit sales or that collections have improved. The debt-to-equity ratio is fairly stable. The
increase in the times interest earned ratio shows the company’s ability to meet its interest
payments has improved. Return on equity shows that returns (profits) to common shareholders
have increased. The gross margin percentage is a significant indicator that profitability is
improving.

P11-4A
Presentations, Inc.: Ratio analysis

Note that formulas shown here use the available information for year 2002 for Presentations, Inc.

1. Return on net income − preferred dividends* $426,000

equity
** average common $5,016,000
stockholders’ equity
8.5%
* no preferred dividends
beg. SE + end. SE
**
2
2. Debt to equity total liabilities $6,217000
,
total equity $5,333000
,
1.2

3. Gross margin gross margin $3,477000

,
percent-
age sales $12,228,000
28.4%

4. Current ratio total current assets $5,800,000

total current liabilities $2,717000
,
2.1

5. Acid-test ratio *short-term net current $1,617000

, + $1,925,000
(also cash + investments + receivables
known as
the quick
$2,717000
,
ratio) total current liabilities
* no short-term securities available 1.3
 Financial Accounting 1/e 207
6. Times interest net interest income $708,000
income expense + taxes
+
earned
$168,000
interest expense
4.2
It is difficult to interpret ratios for one year of data. However, the current ratio is over 2.0, which is
favorable, and the acid-test ratio is over 1.0. The profitability ratios are also favorable. Meaningful
comparisons and interpretations of trends would be possible with two or more years of data or if
industry averages or the ratios of other companies were available.
208 Chapter 11 Financial Statement Analysis
P11-5A
For the Kitchen, Inc.: Ratio Analysis

1. Ratio Definition 2004

Liquidity
a. Current ratio total current assets 1.2

total current liabilities

b. Accounts *net sales 8.1
receivable
turnover ** average net
ratio
accounts receivable
* Credit sales used here
beg. AR + end. AR
**
2
c. Inventory cost of goods sold 3.4
turnover
ratio *average inventory
beg. end.
+
* inventory inventory
2
Profitability
d. Gross margin gross margin $420,000 − $250,000
percentage
sales $420,000
40.5%

2. Creditors and financial managers (within the firm) would be most interested in the ratios
computed here.

3. Kitchen’s current ratio is below the industry average and this may unfavorably affect how
potential creditors evaluate the firm. The company is less liquid, i.e., has a lower ability to meet
short-term obligations than the industry, on average.

P11-6A
Reese Company: Ratio analysis

Ratio Definition 2004 2003

Liquidity
Current ratio total current assets 2.3 1.7

total current liabilities

Acid-test ratio *short-term net current 1.3 .9
(also known cash + investments + receivables
as the quick
ratio)
total current liabilities
* no short-term securities available

Working capital current assets – current liabilities $387,000 $159,000

 Financial Accounting 1/e 209
Solvency
Debt to equity total liabilities 1.2 1.1

** total equity
** CSE + RE

Profitability
Return on equity net income − preferred dividends* 21.3% Net income
not
** average common shareholders’ equity available.

* no preferred dividends
(beg. CSE + RE) + (end. CSE + RE)
**
2
There is not enough information to make an investing decision. Although the company’s ability to
meet short-term obligations is improving and the debt-to-equity ratio is stable, an investor would
want additional information about profitability and market indicators, industry averages, and
financial ratios for other years.

P11-3B
Compass Company: Ratio analysis

1. Note that formulas shown here use the available information for Compass Company.

Ratio Definition 2001 2000

Liquidity
Current ratio total current assets 2.6 3.1

total current liabilities

Acid-test ratio EMBED Equation .75 .85
(also
*short-term net current
known as cash + investments + receivables
the quick
ratio)
total current liabilities
* no short-term securities available

Working capital current assets – current liabilities * $114,287 $131,421

* figures in thousands

Inventory cost of goods sold 2.7 2.3

turnover
ratio *average inventory
* used current year figures:
current assets –
(cash + net current receivables)

Accounts net sales 19.1 17.7

receivable
turnover *average net accounts receivable
ratio
* used current year figure

2. The current ratio, acid-test ratio, and working capital are decreasing, which indicates the
company’s ability to meet short-term obligations has decreased. The inventory turnover ratio is
increasing, which means the inventory is being sold more quickly. The accounts receivable
210 Chapter 11 Financial Statement Analysis
turnover ratio indicates that total sales may have increased in relation to credit sales or that
collections have improved.
 Financial Accounting 1/e 211
P11-4B
ROM, Inc.: Ratio analysis (in thousands)

1. Return on net income $4,699,000 − $4,445,000

equity
*average common $4,699,000− $4,445,000
2
shareholders’ equity
* assumes change in equity is due to net 5.5%
income, no stock issued and no
dividends

2. Debt to equity total liabilities $4,785,000

$4,699,000
total equity
$10,200,000
1.02

3. Gross margin gross margin $10,200,000 − $6,750,000

percentage
sales $10,200,000
33.8%

4. Current ratio total current assets $5,447000

,
total current liabilities $2,785,000
1.96

5. Acid-test ratio
(also
EMBED Equation $1,220,000 + $3,112000
,
*short-term net current
known as cash + investments + receivables $2,785,000
the quick
ratio)
total current liabilities 1.55
* no short-term securities
available

It is difficult to interpret ratios for one year of data. Meaningful comparisons and interpretations of
trends would be possible with two or more years of data or if comparing to industry averages or
ratios of another company.